⬆️ 📉 What rising rates are doing to asset prices (and why)
Some implosions, purchasing power, and cashflow vs enterprise value.
Hey what’s up
It’s been a month since I last wrote (been a busy guy), but I thought I’d drop in real quick to write about interesting things I’m seeing in the investing landscape.
To start, I want to explain a concept that is super important, and I’m going to say it in a few different ways.
So below is a snippet of a monthly letter from a real estate fund that I’m in.
I know it’s long, and I know it uses some complicated-sounding terms, but I really recommend just taking a moment to read the whole thing. Don’t worry about mastering the terminology, you’ll get the gist of it.
(seriously, read it, if you’re on a mobile, flip it sideways to see the font)
To summarize, essentially, a whole bunch of investors in real estate have lost all their money.
A lot hasn’t been “realized” yet, but it has already happened, and there are a bunch more RE deals that will have to face the music before too long as their interest rate caps expire.
Many will lose money, many will be forced to raise the rent on tenants a good bit just to survive (this is guaranteed), some will not be able to refi and have to do capital calls from investors, and many will just try and hold off long enough for lower rates to hopefully return.
Let’s simplify this concept a little bit.
This Tweet explains the exact same concept, just from a consumer point of view.
A $400k mortgage at 2.75% is $1.6k/mo.
A $250k mortgage at 6.75% is $1.6k/mo
Price has to decline by 37.5% for the same monthly payment.
This isn’t good.
— David | Filled With Money (@FilledWithMoney)
Feb 27, 2023
The same salary can now afford a significantly less expensive house vs just 1-year ago.
So either people will buy less expensive homes, or the prices of homes will have to come down (it’ll probably be both).
Now let’s look at this concept from a business owners point of view.
Just a little over a year ago I was in the final stages of selling one of my companies. I don’t generally sell businesses anymore (I collect them), but Mr. Market was being silly and offering me an almost 6x multiple on an ecommerce business, on top of all the inventory cost.
So of course I was taking that offer.
Unfortunately for my partner and I, the deal collapsed at the 11th hour. It was a combination of a lot of things: market uncertainty, aggregator blowups, rising rates, etc.
Now, what is that business worth today?
It’s only worth about 2/3 as much as it was at the beginning of last year.
This business lost 33% of its value in less than a year.
The crazy part though? The business basically still makes the exact same amount of profit, but its enterprise value dropped off a cliff.
Why? You guessed it… rates.
(I’m going to over-simplify here for the sake of the explanation)
The buyers (FBA aggregators) were generally buying businesses of this size with a combination of equity (cash) and debt. The cashflow of the business would pay the interest on the debt, and all the leftover would be profit.
Now with interest rates going up so much, the same amount of cashflow from the business can only support a much smaller amount of debt.
So what happens? It forces multiples down. And my business is worth a whole bunch less.
On top of that, with rates going up, the options for investors to get lower risk yield elsewhere goes up, which sucks liquidity out of those markets.
I can get a 5% yield on zero-risk US treasury bills right now. Why in the world would I take a higher risk and super-pain-in-the-butt 9% yield from buying a business?
(hint: I wouldn’t)
Now, one could argue that maybe my company was never actually worth a 6x. Perhaps it was only worth a 6x in a super low-rate environment where funny-money and mega-debt rules the world, but that’s a topic for another day.
Is there a lesson to any of this Travis?
Maybe a few:
1. Always wonder what your investments will look like in different interest rate environments. Remember rates change absolutely everything about valuations.
2. If you’re investing in RE deals, definitely find out about rate caps (and how long they last) in due diligence. h/t to Rob Barry in investing.io for that one, as I never thought to ask how long they were good for.
3. Be wary of debt. I absolutely hate it, but I realize that with some deals, it’s necessary. The more debt involved the less optionality that exists.
4. And finally, whenever possible, have assets where the value doesn’t matter. Look at my ecom biz I mentioned earlier. Yes the enterprise value fell, but it’s still generating the same amount of cash into my bank account each month. Sometimes Mr. Market will say the biz is worth more, and sometimes it’ll say it’s less, but that cashflow is the ticket to mental freedom.
And that’s all I care about.
Til next time,
Huge Disclaimer in Smaller Font
This content is being provided for information and discussion purposes only and should not be seen as a recommendation to do anything at all, especially not to buy or sell a security. Opinions expressed are that of the author, who is NOT a registered investment adviser, or a financial professional, or can barely even tie his shoes half the time. Do not try and copy the author or you’ll probably lose all of your money and have a rather bad day. There will also be affiliate links in here because I like free money.